Monday, April 7, 2008

"BSC failed not because it had too little capital or too little liquidity, but because the thousands upon thousands of OTC trades which flow through the firm’s books are bilateral rather than exchange traded. It was the understandable fear of counterparty risk, not a lack of capital or liquidity, which killed BSC. The irony is that the “financial innovation” of OTC derivatives and structured assets takes us backward in time to the chaotic situation that existed in the US prior to the crash of 1929."Mr Whalen is a co-founder of Institutional Risk Analytics

If Mr. Whalen is right, and there is strong evidence for that, than regulators are wrong in targeting capital and liquidity issues as the main reason for the current financial crises. This would also explain the unexpected shift in market sentiment since the Fed stepped in and took charge of a significant part of Bear's counter party risks. Bear was maybe the first financial institution in the history of capital markets that was taken out by the sheer force of counterparty risks. Given the amount of derivative contracts to top 25 US commercial banks and trust companies outstanding at more than 175 trillion dollar one can only try to guess who will follow Bear's fate.